3. Easy to trade
While you typically must wait until the end of the day for your mutual fund trade to be completed, you can trade ETFs any time during the day. That can be an advantage, particularly in fast-moving markets. Also, you can set stop, limit, and other order types with ETFs, just as with stocks. This can help you purchase an ETF at or near your desired price, or help limit your downside risk if the market moves against you. Finally, apart from a single share purchase, ETFs have no investment minimums.
Caveat
While mutual funds trade at their net asset value, ETFs can trade above or below the NAV of the underlying portfolio of securities. When markets are functioning normally, or if the ETF is composed of highly liquid securities, the ETF should trade at a market price at or near the NAV of the underlying securities. However, at other times, such as during periods of market turmoil, or if an ETF is composed of less liquid securities, premiums and discounts can develop.
One way to understand whether an ETF is accurately valued against its underlying securities is to look at the intraday indicative value (IIV) for the ETF. The IIV is designed to give investors a sense of the relationship between a basket of securities that are representative of those owned in the ETF and the share price of the ETF on an intraday basis. The IIV is updated by the listing exchange every 15 seconds and provides the investor a way to compare the market price with the ETF portfolio’s net asset value any time during market hours. Liquidity is another important factor when considering the ease of trading an ETF. Highly liquid ETFs are generally easier to buy and sell.
4. Transparency
Because many ETFs track an index, it's relatively easy to know exactly what you own. Each index-based ETF is required to publish its holdings and weightings daily. As an investor, owning an index-based ETF lets you become familiar with the positions and weights in the relevant index as well as the ETF. This can help you identify any overlap across your portfolio and provide you with timely risk measurements associated with the ETF’s holdings. Mutual funds also publish their holdings so you can identify any overlap across your portfolios, but just not as frequently. A mutual fund typically publishes its holdings every 1 to 3 months, depending on the fund’s investment policy.
Caveat
In general, ETFs are either index-based or actively managed ETFs. As with mutual funds, actively managed ETFs don’t seek to “track” their benchmark (they seek to outperform it). Although you will still have visibility into the actively managed ETF holdings, you will need to make sure your portfolio continues to be invested consistent with your overall risk tolerance and asset allocation strategy. Because the expense ratio is typically higher on actively managed ETFs—and expenses decrease fund returns—make sure you're getting the right level of return for the additional risk you are taking.
5. Tax efficiency
Although both ETFs and mutual funds are required to distribute capital gains annually, some ETFs may be more tax efficient than similar mutual funds. Why? As we mentioned above, ETF investors can only redeem ETF shares on an exchange and they can't redeem their shares directly with the fund. When faced with redemption requests from investors, ETF managers usually don't have to sell individual securities to meet these redemption requests. Instead, the ETFs can deliver baskets of their underlying portfolio's stocks "in-kind," rather than cash, to large investors, known as authorized participants or "APs." APs deal directly with the ETF and in this regard work like a clearinghouse, matching the shares of the underlying securities when redemptions come in with those required to meet the demand of new investors. ETF managers can use this in-kind redemption process to remove the stock shares from the portfolio with the lowest cost basis, limiting the ETF’s potential for distributing gains.
Additionally, since most ETFs closely track their underlying index, their trading activity tends to be low, as with index funds. ETFs typically generate a lower level of capital gain distributions relative to actively-managed mutual funds. Of course, tax treatment may vary based on fund structure, asset class, holding period, and other factors. Due to the varying tax treatment associated with different ETFs, it's important to understand the fund structure and associated tax treatment before investing.
Caveat
While capital gains distributions are often lower with ETFs than with similar mutual funds, that's not always the case. Also, some ETF distributions are taxable as ordinary income. So, if you're considering such income-generating ETFs, a tax-advantaged account might make sense.
In next blogpost, we will discuss the cons of ETFs.